Roundtable Report: At the outset of 2014, Morningstar strategists dig into the market's current valuation and expected return, seek out high-quality U.S. and foreign stock opportunities, size up the role of cash today, assess the Fed's impact on the market, and reveal the best ways to fight inflation.

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Stronger Equity and Housing Markets Give Boost to Financials

After years of underperformance, the battered United States financial sector has been off to a strong 2013, driven by continued good news from the housing industry and more gains from the stock market. But many of the same headwinds facing the sector are unchanged--starting with continued low interest rates (which will remain so for the foreseeable future) and the lower interest-rate-spread revenue that banks have accepted. Added regulation has meant another layer of costs for financial services companies, and counterparty relationships with European banks could mean losses for U.S. banks if Europe's banking system collapses.

Despite these headwinds, we see some attractive drivers that could continue giving a lift to the financial sector, even if rates remain low. Further macroeconomic improvements and lower unemployment rates should increase borrowing and repayment rates. Banks have cut costs in other places, including reducing staff and branch locations, which we believe could offer better operating leverage as the economy improves. And a better economy also could boost investment banks' financial advisory and equity trading businesses. And all of this is merely a prelude to the improved spreads that the financial services sector could begin enjoying once interest rates begin rising, which could happen as soon as a year and a half from now.

For those investors who are comfortable with all of the above risks and are interested in a basket of U.S. financial companies, the exchange-traded fund Financial Select Sector SPDRXLF is an appropriate tactical satellite holding, offering broad U.S. financial services sector exposure.

The index that this exchange-traded fund seeks to replicate defines the financial services sector broadly to include commercial banks, diversified financial services firms, capital markets companies, insurers, REITs, and consumer finance firms. The result is a market-capitalization-weighted portfolio of 80 firms with a certain amount of concentration, as XLF's top 10 holdings make up slightly more than 50% of its assets.

The financials sector offers high beta exposure to the U.S. economy. The reason is that even seemingly small changes in unemployment and consumer confidence can have an outsize impact on loan repayment rates and the willingness to borrow. Other aspects of the economy, including the health of the housing market and even the shape of the yield curve, can provide headwinds or tailwinds for financial firms.

In recent years, owning XLF has required investors to be comfortable with far more volatility as a whole. Indeed, XLF's 31.8% volatility of return over the past five years has been some 41.0% greater than the S&P 500 Index's 18.9% volatility of return. An investor in this fund should have a high risk tolerance but could benefit from positive trends that may continue in the near term, including an improving macroeconomic environment, a further strengthening in the housing sector, and a continued strong equity-market performance.

This ETF offers the diversification that we think is prudent in a sector where some aspects of companies' operations are so opaque that it can be difficult to gauge their true risk exposure. One need look no further than the multi-billion-dollar trading loss at JPMorganJPM in 2012 to understand the perils of single-stock investing in the financial services sector. XLF's comprehensive sector portfolio mitigates company-specific risk while offering pure exposure to the U.S. financial services industry. We believe this ETF is an effective tool for investors seeking to overweight the financial sector within a broadly diversified portfolio.

Fundamental View A variety of factors has continued to pressure U.S. banks' profitability. The big story has been low interest rates. Interest-rate-spread revenue at most U.S. banks has stayed the same or has fallen, and with rates expected to stay low for some time to come, bank margins will remain pressured. Some other issues negatively affecting U.S. banks in recent periods have included increased regulation that has blocked deposit-taking banks from engaging in proprietary trading, limited debit-card fees, higher compliance costs, and high unemployment, which generally tends to keep borrowing and repayment rates low.